Registered representatives with an established customer base
may, from time to time, change their association from one firm to
another and may wish to bring with them customer assets, including
mutual funds and variable products. In some cases these mutual
funds or variable products may be held directly with the product
issuer or they may be proprietary to the representative's prior firm
and the sponsor may not permit them to be transferred into the
customer's account at the new firm. Even nonproprietary products
may not be freely transferable if the sponsor does not have a dealer
or servicing agreement with the new firm.

In cases such as these, the new firm may not sell or in some cases
even service the investment or receive trail commissions from the
distributor. In these situations, the representative may be inclined
to recommend the liquidation and replacement of the customer's
investments with other, similar investments. Although the ability to
provide the customer with service in connection with an investment
can be a relevant factor to consider in connection with the decision
whether to retain the investment, any recommendation by the firm
or its associated persons to sell a product and to replace it with
another one may be made only after fully assessing the suitability of
the transaction for the customer and determining that the transaction
is in the customer's best interests in view of all considerations. Member firms and their associated persons may not reach any suitability determination or make any recommendation on the basis that the purchase of a security or sale and
replacement of a security will yield greater remuneration for them. Moreover, the
representative should disclose to the customer all of the relevant facts and bases
for the recommendation. See, e.g., Notice to Members 99-35 (May 1999).

Questions/Further Information

Questions concerning this Notice should be directed to Kosha K. Dalal, Associate
General Counsel, Office of General Counsel, at (202) 728-6903.

Background and Discussion

It is not uncommon for an individual registered representative or a group of
representatives with an established customer base to terminate their association with
one firm in favor of another. In such instances, one of the principal interests of the
acquiring firm is ensuring that the newly associated representatives retain as much as
possible of the customer base they serviced. Depending upon the nature of the business
in which the representative was engaged, a number of the customers he or she serviced
may own mutual funds and variable products that the prior firm was authorized by a
sponsor to sell and service pursuant to a dealer or servicing agreement. The agreements
frequently require that the sponsor pay the prior firm various distribution, marketing
and/or servicing fees, also referred to as "trail commissions," which may benefit the
representative.

When a representative who has sold such a product chooses to associate with a new
firm, however, there may be impediments to the representative's ability to continue
selling or servicing these investments, as well as receiving trail commissions from the
sponsor for products the representative previously sold or serviced. For example,
the product might be held directly with the issuer, it might be proprietary to the
customer's prior firm and not portable, or the product sponsor might not permit the
product to be transferred to the customer's account at the new firm. Even in the case of
nonproprietary products, the new firm might not have a dealer or servicing agreement
with the sponsor.1 In other cases, the new firm may have such an agreement, but the
representative's new firm may not be able to receive trail commissions on previously
sold business because those trail commissions contractually belong to the previous firm
that sold the product and it might not agree to relinquish them to the representative's
new firm.

In these situations, the transferring representative may be tempted to recommend to
customers that they replace their existing mutual funds and variable products with
other investments, without adequately considering the customer's best interests and
the suitability for the customer of those recommendations. Such inappropriate
recommendations might be premised upon the fact that the new firm or the
representative will no longer receive trail commissions for the customer's current
investments or that the representative will generate more income by replacing an
investment than recommending that the customer continue to hold the investment
through the representative's prior firm.

A recommendation to liquidate, replace or surrender an existing investment must be
suitable and based upon the customer's investment needs and not the financial needs
of the firm or its associated persons. See, e.g., Notice to Members 99-35 (May 1999).2
A firm may consider the fact that the firm lacks a dealer or servicing agreement with
the product sponsor and, therefore, the registered representative cannot provide the
customer with the service that the customer desires with respect to the product. The
suitability analysis must also include other considerations, however, including whether
the customer's mutual fund or variable product is subject to a contingent deferred sales
charge or a required holding (surrender) period, or has other features that materially
affect its value or liquidity, and the fees and expenses associated with the new product
being recommended. Accordingly, firms should have procedures in place, including
supervisory procedures, that are specifically designed to review and evaluate
investment recommendations relating to mutual funds and variable products that are
made by newly associated persons to their existing customers. See NASD Rule 3010 and
Notice to Members 99-45 (June 1999).

These procedures should include at least the following:

• When conducting due diligence concerning a prospective new registered
representative, the new firm should seek to learn the nature of the
representative's business and the extent to which he or she offers investment
products for which the new firm would need a dealer or servicing agreement
in order for the representative to sell and provide service. The new firm should
determine whether it would seek such agreements.

• If the new firm is unable or unwilling to service a customer's mutual fund
or variable product, the new firm or the registered representative should
advise the customer of this fact, as well as the options the customer may
have to continue to hold the investment at the customer's prior firm, before
recommending that the customer liquidate or surrender the investment.3

• Any recommendation to liquidate, replace or surrender a mutual fund or
variable product must be suitable for the customer based upon the customer's
financial needs and investment objectives. Recommendations should not be
a function of the desire of the firm or its new representative to obtain
compensation that it would not otherwise receive were the customer to
retain the previously sold investment.

• For a reasonable period following the association of a new representative, the
new firm should review replacements recommended by the associated person
with a view to identifying any recommendations to liquidate or surrender
mutual funds or variable products that may be inconsistent with the customer's
investment needs and objectives or that have not been preceded by appropriate
disclosure to the customer. Special supervisory consideration should be given to
those transactions involving the replacement of a customer's existing variable
annuity product with a "bonus variable annuity" offered by the new firm.4
The firm should review these transactions with a view to ensuring that full
disclosure is made to the customer regarding all fees, expenses and surrender
charges that may apply to the replacement product; a "bonus" on premium
payments may not be considered an "offset" against any other fees or
expenses, including surrender charges applied to the replaced product.5

1Rule 11870 of the Uniform Practice Code
(Customer Account Transfer Contracts)
addresses the transfer of assets held in a
customer's securities account. While the rule
provides that member firms must, upon a
customer's request, expedite and coordinate
the transfer of securities account assets from a
carrying firm (i.e., the customer's current firm)
to a receiving firm (i.e., the customer's new
firm), the rule identifies several categories of
securities as "non-transferable assets,"
including, but not limited to, an asset that is
a proprietary product of the carrying member,
as well as an asset that is "a product of a third
party with which the receiving member does
not maintain the relationship or arrangement
necessary to receive/carry the asset for the
customer's account ." SeeRule 11870(c)(1)(D).
In such instances, Rule 11870(c)(3) provides
that where the non-transferable product is
proprietary to the customer's carrying firm,
the carrying firm must notify the client of the
status of the non-transferable asset and seek
instructions as to whether to liquidate the
product, continue holding it for the customer's
benefit or deliver it to the customer. Similarly,
Rule 11870(c)(4) provides that where the
customer's receiving firm cannot accept a
product because, for example, the receiving
firm does not have a servicing agreement with
the product sponsor, the receiving firm must
notify the customer and seek instructions as
to whether to liquidate the product, leave
the product with the carrying firm for the
customer's benefit, deliver it to the customer
or deliver it to the product issuer to hold for
the customer's benefit.

2 "The registered representative and the
registered principal should determine, based
on the information provided by the customer
and their own knowledge of the product
features, that replacing the existing contract
with a new contract is suitable for the
customer. Consideration should be given to
such matters as product enhancements and
improvements, lower cost structures, and
surrender charges."

4 A bonus variable annuity offers premium
credits toward the value of the variable
annuity contract at a specified percentage
usually ranging between 1 percent and 5
percent of the purchase payment made.

5 The guidance set forth in this Notice would
also apply in those situations in which a
firm or its registered representative attracts
a new customer who has mutual fund or
variable product holdings with his prior
firm. In such cases, the customer's new firm
and representative must be cognizant
of the aforementioned when making
recommendations that concern these holdings.